There are plenty of online articles that talk about personal finance. Many of them deal with saving for retirement and often contain the sentence “to have $x by age x, you need to save $x, assuming 8% return”. In fact, I ran into an article today, quote:
If you are 35 and starting from scratch, for example, you need to save around $735 per month to have $1 million by age 65, assuming an 8% average annual return.
I haven’t punched out the numbers, but I’m sure it’s correct. Unfortunately, vast majority of readers will not get 7-8% return over the next 30 years.
People greatly misuse this magical 8% figure. Yes, it’s true that long-term performance of S&P 500 (my favorite index, if I had to pick one) did yield similar gain. From 5/2/1983 (162.39) to 5/1/2013 (1,582.70), S&P 500 has compounded annual growth rate of 7.89%, an impressive record over 30 year period. If you span it out to 50 years, the percentage figure drops closer to 7% mark, but it’s still great return nonetheless.
But I would argue that none of those returns are very much likely going forward. Two primary reasons are:
A) Past performance is not indicative of future results
Ah, the familiar phrase that you can find in small tiny print at the bottom of financial documents.
If S&P 500 returns 7% annually for the next 30 years, it will be sitting at 12,047.91 on 5/1/2043. If S&P 500 returns 8% annually for the next 30 years, it will be sitting at 15,926.17 on 5/1/2043. I would argue that there is almost no chance that S&P 500 can reach those levels in the next 30 years.
Unprecedented amount of wealth has been generated over the last three decades, not just in the United States but globally. World Bank estimates Gross World Product (GWP) to be $68.98 trillion as of 2011. If we go back 30 years, it was $11.31 trillion. The growth rate comes out to 6.21%. There are obviously many factors in play when determining stock prices, but in the grand scheme of things, such growth rate in GWP is required for S&P to enjoy similar success it had. It’s true that companies can squeeze profits without a growing economy, but there needs to be a solid economic growth for profits to increase over extended period of time. Will GWP be around $420.42 trillion in 2041 (6.21% growth rate)? Or even $237.69 trillion (4.21% growth rate)? Can we really keep up with all the advances we’ve had in the last few decades? But more importantly…
B) Market volatility and lump-sum dilemma
Volatility, which in turn makes timing important, makes the 8% claim inherently difficult to actually achieve. $36,000 investment in 5/2/1983 would’ve grown to $350,866.43 on 5/1/2013, which results in 7.89% annual gain over the 30-year period. But this is not how vast majority of people invest; they do it over time as they do not have one large lump sum to put away.
If one invested $100 per month for the same 30-year period, the money would’ve grown to $113,963.45, which results in meager 3.92% annual gain. Of course, that is still relatively good return over time, but it’s nowhere close. The less compounding effect over time also greatly reduces the amount of investment as well.
Wait, was the return on the latter example diminished by the fact that S&P 500 has done a round trip back and forth over the last 13 years? This is a valid point, so I cherry-picked a 30-year period which has seen pretty much a straight line up: 3/2/1970 to 3/1/2000. Over this time period, S&P 500 has returned compounded annual growth rate of 9.84%. $36,000 investment would’ve grown to $601,337.42. However, $100 per month investment for the same 30-year period would’ve grown to only $321,439.57, resulting in 7.57% growth rate. Yes, it’s still fantastic, but not the same.
It’s absolutely true that market volatility can help an investor score a better return over time, as it allows one to invest at a lower cost basis. But that’s not a “general” investor.
You should think hard when assuming anything in finance. 8% annual gain is not an exception.